‘Lower valuations are not equal to higher returns’

Contrary to popular wisdom and the findings of earlier wealth creation studies, low valuations have not resulted in higher returns, according to the latest wealth creation study from Motilal Oswal.

Companies trading at less than ten times their earnings and less than their book value, gave lower returns than those with a P/E of 15 and higher P/B ratio, in the five year period from FY05-10. In another counter-intuitive stroke, Raamdeo Agrawal, Joint MD
& Co-founder of Motilal Oswal Financial Services explains that commodity companies may do better than those with strong brands in the future.

Excerpts from an interview with DNA:

What common striking features have you noticed across all the companies that have emerged as the consistent wealth creators?
The basic success formula is to buy into good businesses, run by good management at reasonable price and then the economy will drive them to different heights. The only premise is that underlying business should net into the bad times for them to perform consistently. If the business remains solid, say like banks which keep on growing at 15% or so, they would definitely give good returns if you hold them for 5-10 years.

One thing that consistent wealth creators have shown over time is that these companies are in non-cyclical business particularly consumer-oriented companies in FMCG, pharma, autos, banking, IT etc that keep on scaling their business year-after-year and thereby keep making money regularly.

Another important thing is to look at companies with good managements, where people are of high calibre as they are the ones that make it happen - creating unique situations. If you ask me how to figure out good management, then that is a complete art. You cannot go about finding about the management personally!

How do franchisee businesses compare as wealth creators with commodity companies?
Recently, what we have seen is that commodity companies are also making an appearance among the most consistent wealth creators. This is only possible if underlying business runs in sustained fashion and that has been the case in last 8-10 years. People earlier used to say that you should buy franchise business and not the commodity business, but my sense is that probably the time has come for commodity companies where they may make more money than brand companies. The commodities have seen growth in demand for past few years; and over next 10 years or so, the emerging markets such as India and China, which are drivers of global growth, would need more of commodities. So it’s quite possible that commodity may remain fairly heightened and hence commodity companies would deliver much better performance consistently.

How can retail investors spot such wealth creators?
One thing you must remember is that if you want to make excess market returns, then you need to bring complimentary skills on table. You should have specific knowledge about the product, industry and business for you to gain more in terms of returns. For example, if you buy a large cap bank, which is in good business of banking with good management available at good price, you may make reasonable returns. But to buy a small cap company and make lots of money, you definitely need to bring in skills to understand what to buy or what not to buy.

Since retail investors in general, barring a few, bring very little complimentary skills, so if one is looking to make fantastic amount of money, the best way is to go with well-managed mutual funds, so that you are not exposed to the volatility of individual stocks. And if you are skilled and smart, confine yourself to the business you understand and know well.

What could be the reason for very little retail participation in markets?
The problem with retail investors is that they don’t trust the mutual funds from whatever experience they had in the past and they cannot do it themselves either. So they are stuck.

But those who are smart, they have been active in the market. I think coming into markets is big problem for them, as markets require skill and every time they try to come, they have experienced that there are sharks in the market that are difficult to beat. Even public issues are nowadays fully priced, but the moment there’s something left on the table, there’s no dearth of retail applications. That’s the reason I think people are not coming into the secondary markets, as they realise that they lack that skill.

Any risks you foresee for the markets or flows in general, in near term?
At the moment, one of the headwinds is rising crude prices, which may lead to higher inflation. Any delay in reforms related to deregulation of oil prices or DTC/GST rollout by government may also impact the corporate earnings though at the moment, expected corporate earnings are looking good. The political risks and corporate governance issues have emerged as the biggest concerns in the last few weeks. With this kind of political management and recent scams, flows may get muted in the coming fiscal if government does not take any action. Also next year, the US is expected to do much better, which would take away the compulsion to come into emerging markets. So there are some challenges in the near term as we are used to certain kind of flows for markets to move up.

Any opportunities you see in the midcap and small caps that you have corrected a lot recently?
The markets have hardly corrected 7-8%. Most stocks that have come down heavily are the manipulated ones while the quality ones haven’t corrected much. So if you know that the company is good and it has been unnecessarily hammered down, they you may go and buy. But then you should know! There’s no solution to ignorance. This is not a lottery place. You must have an understanding of the company before you take a call. It’s better to give your money to acknowledged fund managers and enjoy the fruits rather than punting or relying on others recommendations.

How do you see markets in the coming fiscal?
After a tremendous run of around 81% last fiscal, there is little scope for markets to rise further from here on, may be we can rise by another 4-5%. But for this fiscal, we may see markets ending with 12-13% gains at the best.

However, if everything goes correctly, modest recovery of this year would set up the backdrop for much bigger rise in FY12. This year, we have had a brilliant monsoon, full effect of that would be reflected in inflation next year. According to me FY12 would be a stable and good year for markets, unless this scam kind of news flow comes once again, but overall fundamentals are very much in place.